Long Calls/Puts vs. Spreads (Long on the Wings)

Quote from CPTrader:

Thanks!

With the Hoadley pakcage, do you supply your own volatility estimates & interest rate estimates or does the package have its own source for volatility. What's the data source for these calculators - user supplied or software supplied? If user supplied, where can I get good options data?

Thanks again!
More...

A frequent question I get is "What is the correct interest rate to use." The answer is simple - YOUR interest rate. If you're using money you borrowed from a loan shark at 140% annual interest, then use that! If you're using money you'd otherwise put in T-bills at 2%, then 2% is the right rate to use.

If you want to actually supply a volatility estimate, then yes, Hoadley gives you tools such as GARCH that permit you to calculate a volatility from the actual market movement over a given period of time. That's not how I do it though - like most option traders I use implied volatilities.

As for data sources - you can tap into public data sources such as Yahoo or MSN money. If you have an account at certain brokers such as IB and TD Ameritrade, or with a data provider such as E-trade, his software will log into your account and pull quotes from there. The platform is Excel so the better you are at Excel the more you will be able to get out of the software.
 
At the risk of sounding silly, why not enter into atm debit iron condor. I don't know the name of such a positoin; however, it takes advantage of two shortcomings of the IC. The Iron Condor is a negative risk:reward position, and many recommend entering an IC at least 3 strikes otm. What I am proposing for your feedback is as follows:
1) Using the positive risk:reward of the debit spread, enter a bull call spread and a bear put spread
2) Enter both positions atm (or atm straddle the buy positions)
3) For example, with AAPL... one side will lose about $2 and the other side can gain as much as $5. Although it's possible that both sides could lose, it's highly improbable because I'm entering atm. Also, market volatility is neutralized with vertical spreads, so it's o.k. (even ideal) to enter such trades during periods of high IV.

Your Thoughts...

Walt
 
Walt, an ATM IC will very likely lose money. You will not receive enough credit to offset the likelihood of a complete loss on one side of the spread. For example, if you enter two $1 wide (as small as you can get) spreads you will probably get less than $0.90 in total revenue resulting in a likely loss of 0.10 or more. Taking the SPY as an example ( and it is probably one of the best possible candidates for this idea) -- the theoretical price for both November ATM spreads (93/94 's) added together is quoted at 0.92. This is midpoint for each spread which would be ideal, and not typical of normal trading--usually retail investors have to give up a nickel or dime to do that..

Explain why you would want to do that.
 
Oops, didn't read your post clearly enough. You were talking about debit spreads.. In that case, you would pay mighty close to a dollar to make a dollar. After slippage and commissions, you will make zip all.
 
Hi John,

I'm sorry for not being clear about my strategy. I'm talking about the opposite of an IC. That's why I was calling it a "debit" IC. In other words, two atm debit spreads is what I'm talking about. This would be a net cost to enter such a position. For example, with AAPL, it'll cost me about $2 on each side. The winning side will yield $5. That's a 25% ROI. I would especially enter such trades right before earnings announcements. The only negative is that the one of the legs (either the long call or the long put) must move from atm to itm more than 80% of the time. I think that is a VERY high probability trade.

Am I off base on this???
 
Quote from JohnGreen:

Oops, didn't read your post clearly enough. You were talking about debit spreads.. In that case, you would pay mighty close to a dollar to make a dollar. After slippage and commissions, you will make zip all.
More...

In looking at AAPL, I don't see how slippage & commissions will prevent me from being profitable. It seems that at worse case, the slippage & commissions would eat into about 30% of my profit margin. Therefore, instead of clearing $1 per trade, I'd clear only $0.70 per trade. Is there another type of trade that gives a better ROI payout while having an equal or higher probability of success. Just as likely as it is for atm IC to lose, I'm betting that atm debit straddle spreads are as likely to win. Also, to be conservative, I can set my limit orders on the slippage. If I don't get the terms I want, then I won't do the trade.

Walt
 
Walt,
Good conversation so far. Now can you set up a specific example, using AAPL for example. Pick your spreads and use real, during the day quotes, and we'll have a close look at it. By the way AAPL is one of the best to trade relative to slippage because it is very liquid.

Looking forward to continuing the conversation-- by the way, don't forget about the wide IC ideas. I have used them and they provide adjustability and with protective wings, they are OK to trade in most market environments--last month was a bit wild, though!!

In today's ultra high IV environment. You can make your IC 500-600 points wide for NOV expiry and still collect a pretty good premium!
 
Food for thought. Why not look at short IC's and IB's (iron butterflies) that are vega neutral? For the IB, you would sell the put/call ATM for the near month, and your wings would be placed (longs of course) OTM in the far month. Make each wing vega neutral to its complement.

Body of the IC (the near-month short put/call) can be placed 10-15% OTM and the wings, again, placed similarly to the IB--vega neutral to its complement. Each spread (put diagonal calendar and the call diagonal calendar) will probably yield a credit. So, if the underlying, say, finishes near the strike of the short put, the put diagonal will show maximum profit and the call diagonal will show minimal profit (the credit) and vice versa. Interesting to look at the action near the wings--others can comment. As far as the IB, I really can't see an advantage here at all--so comments are welcome.
 
Quote from dmo:

A frequent question I get is "What is the correct interest rate to use." The answer is simple - YOUR interest rate. If you're using money you borrowed from a loan shark at 140% annual interest, then use that! If you're using money you'd otherwise put in T-bills at 2%, then 2% is the right rate to use.

If you want to actually supply a volatility estimate, then yes, Hoadley gives you tools such as GARCH that permit you to calculate a volatility from the actual market movement over a given period of time. That's not how I do it though - like most option traders I use implied volatilities.

As for data sources - you can tap into public data sources such as Yahoo or MSN money. If you have an account at certain brokers such as IB and TD Ameritrade, or with a data provider such as E-trade, his software will log into your account and pull quotes from there. The platform is Excel so the better you are at Excel the more you will be able to get out of the software.
More...

Thanks dmo for all your help. To be clear, when you say you use "implied volatilities" - in essence what you do is to input current market prices into the option calculator to extrapolate the implied volatility. Is that correct?
 
Quote from CPTrader:

Thanks dmo for all your help. To be clear, when you say you use "implied volatilities" - in essence what you do is to input current market prices into the option calculator to extrapolate the implied volatility. Is that correct?
More...

Exactly correct. Then once I get the implied volatility for the ATM options, I have a baseline against which I can compare other options to see if they are relatively "cheap" or "expensive."

I'm only interested in whether options are cheap or expensive compared to each other, not compared to the actual volatility of the underlying security. Not that it would be impossible to construct a strategy based on comparing IV to actual volatility, it's just very difficult because the volatility that matters is the volatility that WILL exist from now until expiration, and how do you know what that will be?

But if you do have reason to believe that future volatility will be different from existing volatility and - more to the point - from existing implied volatility, then that is certainly a legitimate play.
 
You must log in or register to reply here.
Back
Top